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"I told you so!"

Posted 28 October 2008 - 1:00am by Harry Kat

Hedge Dragon

Watching TV and reading the newspapers, it appears that the "I told you so" season has arrived, as I've seen quite a number of people claim they saw it all coming a long time ago. I'm not going to make that same claim, as I didn't predict the mayhem that we've experienced over the last two months. I simply never thought Hank Paulson's hidden agenda would stretch so far as to let Lehman Brothers go under and thereby create the acute crisis of confidence we have experienced. My "I told you so" concerns hedge funds' failure to protect investors during the recent crisis. After it became clear that hedge funds weren't generating the super-returns that people were looking for, about 5-6 years ago the hedge fund marketing machine changed its tune and started to emphasize the role of hedge funds as diversifiers. Hedge funds were said to generate 'absolute returns', i.e. returns uncorrelated with stocks and bonds. Many investors bought into that story, seriously expecting hedge funds to protect them in troubled times.


Over the past 5 years I have spoken on this subject at over 150 conferences and seminars worldwide and written numerous articles in newspapers and journals. One of the main points that I have been making is that a diversified portfolio of hedge funds typically does not offer investors the diversification benefit they are told to expect. If you put hedge funds that follow different strategies together in a basket, most of the strategy specific elements diversify away. What is left is a portfolio that is mainly driven by equity and credit risk.

As a result of the high equity and credit exposure, the average hedge fund and fund of funds portfolio doesn't make a very good diversifier at all. Whenever I have said this over the past 5 years, people have typically responded with a "Yes, very interesting, I think lunch is about to be served" attitude. Only a few sophisticated investors have taken this advice to heart and restructured their hedge fund holdings accordingly. At this point in time, major stock markets are down 40-50% and funds of hedge funds are down 15-20% for the year. The hedge fund investments of the few investors that did re-arrange their portfolios only came down 3-4%, while investors that swapped their hedge funds for the FundCreator-based Aquila Capital SVMN Fund are up 3%.

Need I say more?

It is interesting to see how eager people still are to continue the hedge fund myth. Over the last couple of days, I have heard several people say: "my hedge funds came down 15%, but that is still a lot better than the 40% I lost on my stocks", suggesting that hedge funds did deliver on their promise. Unfortunately, this is another nonsense argument. An average stock portfolio has 15% volatility, while an average hedge fund
portfolio has a volatility of 5%. Under those assumptions, the probability of an equity portfolio losing 40% is more or less equal to the probability of a hedge fund portfolio losing 15%. In other words, taking into account the difference in risk profiles, hedge fund performance has been at least as extreme as that of the stock market. Now who would ever have predicted that?

Body

Hedge Dragon

Watching TV and reading the newspapers, it appears that the "I told you so" season has arrived, as I've seen quite a number of people claim they saw it all coming a long time ago. I'm not going to make that same claim, as I didn't predict the mayhem that we've experienced over the last two months. I simply never thought Hank Paulson's hidden agenda would stretch so far as to let Lehman Brothers go under and thereby create the acute crisis of confidence we have experienced. My "I told you so" concerns hedge funds' failure to protect investors during the recent crisis. After it became clear that hedge funds weren't generating the super-returns that people were looking for, about 5-6 years ago the hedge fund marketing machine changed its tune and started to emphasize the role of hedge funds as diversifiers. Hedge funds were said to generate 'absolute returns', i.e. returns uncorrelated with stocks and bonds. Many investors bought into that story, seriously expecting hedge funds to protect them in troubled times.


Over the past 5 years I have spoken on this subject at over 150 conferences and seminars worldwide and written numerous articles in newspapers and journals. One of the main points that I have been making is that a diversified portfolio of hedge funds typically does not offer investors the diversification benefit they are told to expect. If you put hedge funds that follow different strategies together in a basket, most of the strategy specific elements diversify away. What is left is a portfolio that is mainly driven by equity and credit risk.

As a result of the high equity and credit exposure, the average hedge fund and fund of funds portfolio doesn't make a very good diversifier at all. Whenever I have said this over the past 5 years, people have typically responded with a "Yes, very interesting, I think lunch is about to be served" attitude. Only a few sophisticated investors have taken this advice to heart and restructured their hedge fund holdings accordingly. At this point in time, major stock markets are down 40-50% and funds of hedge funds are down 15-20% for the year. The hedge fund investments of the few investors that did re-arrange their portfolios only came down 3-4%, while investors that swapped their hedge funds for the FundCreator-based Aquila Capital SVMN Fund are up 3%.

Need I say more?

It is interesting to see how eager people still are to continue the hedge fund myth. Over the last couple of days, I have heard several people say: "my hedge funds came down 15%, but that is still a lot better than the 40% I lost on my stocks", suggesting that hedge funds did deliver on their promise. Unfortunately, this is another nonsense argument. An average stock portfolio has 15% volatility, while an average hedge fund
portfolio has a volatility of 5%. Under those assumptions, the probability of an equity portfolio losing 40% is more or less equal to the probability of a hedge fund portfolio losing 15%. In other words, taking into account the difference in risk profiles, hedge fund performance has been at least as extreme as that of the stock market. Now who would ever have predicted that?